Anyone who has been involved with the world of finance or business understands that accounting is a critical component. Without it, how would we know whether a company is doing well or not?
In an economic system where even small businesses have to present data as if they were publicly traded corporations in order to get funding, accounting is simply a must-have skill for those who hope to hold any sway in the business world.
The first thing you should know about accounting, and the most important term you should know about:
You may have wondered, “Why are businesses all about making profit? Is it really that important?” The answer is a resounding yes. A business must make profit in order to survive, plain and simple. Profits are essentially the money left over after expenses are taken into consideration.
If you’re still confused on the idea of profits, think of them like this: if you had $100 bills in your hand after spending some time at Disneyland with your family, then your net income would be represented by that remaining money you have in your hand.
Another very important term related to accounting and profits:
2. Gross Profit
Gross profit is similar to net income (profit), but it’s more specific and calculated differently than its more general counterpart. Gross profit is the amount of money that a company makes when accounting for only the goods that they sell, not including expenses like labor and materials. The formula for gross profit looks like this: ( total sales – cost of goods sold ) = gross profit
One more term to help you understand how businesses make their money through accounting:
Expenses are the exact opposite of profits; expenses reduce your net income/profit by taking up space in your budget, so when you take away your expenses from what you made, you’re left with whatever’s leftover. An expense is exactly what it sounds like – it is an amount spent on something that reduces the value of whatever or whoever spends it.
For example, say you bought a brand new Mercedes for $100,000 – that’s the expense; you lost $100,000 of value (you gave it away to whoever is driving your car now).
4. Cash Burn Rate
This term is used specifically for companies, not individuals, and it’s probably the most important term on this list. If a company has cash burn rate , it means that their cash flow (the amount of money coming into and out of the company) is negative.
A negative cash flow can spell financial disaster pretty quickly; if a business doesn’t have enough money coming in to cover its daily operations, then eventually bankruptcy will occur.
To calculate your cash burn rate, just take how much cash your business makes per month and subtract how much you spend per month; whatever number is left over tells you how much your cash flow is.
5. Operating Expenses
Operating expenses are just like regular expenses, but they’re associated with the “operations” of a company (the running of its daily functions). These can include things like rent, utilities, etc – basically anything that’s not an investment in the business itself (buying tools and materials to make widgets, for example).
If you want to get specific about it, you could call marketing and advertising operating expenses because they don’t directly contribute to making your business money; instead, they attract more customers which costs your business nothing (since customers actually pay for this service) while potentially increasing how much profit you make.
6. Fixed vs Variable Costs
Fixed costs are exactly what they sound like – it’s an expense that you can’t (or won’t) change no matter how much money your business makes. The cost of labor, utilities, rent, and materials are usually considered fixed costs because if you make more/less money you won’t alter the amount of these expenses.
Variable costs , however, are expenses that depend on how much your company makes; this means that if there is a direct correlation between how much money you spend and how much you make. For example, say that for every widget you sell, 1 penny goes towards paying for labor.
If you’re selling 1000 widgets per month then your labor expenses would be $10 (1 cent x 1000 widgets = $10). If one month suddenly your company starts selling 2000 widgets per month, then your labor expenses would double to $20. Variable costs increase when you make more money from sales.
There you have it – the 6 most important terms to know in order to understand how businesses make money.